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What is the Difference Between a Tax Credit and a Tax Deduction?

Doing your taxes can be very confusing because there is a lot of complicated terminology that you need to know. This is why it is a good idea to get help from a Virginia tax attorney if you want to try to reduce your tax bill, maximize your deductions, and ensure you are in full compliance with tax laws.

Two of the most important terms that you will come across when doing your taxes are tax deduction and tax credit. Both deductions and credits reduce the amount of taxes that you must pay to the Internal Revenue Service. However, deductions and credits work differently.

Understanding Deductions and Credits

Tax deductions, such as the mortgage tax deduction, will reduce your taxable income. Deductions allow you to pay for certain things – like your mortgage interest or a deposit that you make to a 401(k) or an IRA – with money that you are not taxed on.

When you take a tax deduction, you subtract the amount of your deduction from your taxable income. For example, if you make $38,000 and you have a $1,000 tax credit, you reduce your taxable income to $37,000. Your savings is determined by your tax bracket, since you do not pay taxes on the amount that you deducted. If you deduct $1,000 and are in the 25% tax bracket, you save $250 ($1,000 times 25%).

A tax credit, on the other hand, is a dollar-for-dollar reduction to your tax bill. If you owe $5,000 in taxes and you have a $1,000 credit, the $1,000 reduces the taxes you owe so you now only owe $4,000 instead of $5,000. Tax credits are obviously much more valuable than tax deductions because they reduce your tax bill by substantially more. The Earned Income Tax Credit is an example of a tax credit.

Many tax credits are not refundable. This means that if you are entitled to a $1,000 credit but you have not paid at least $1,000 in taxes, you will lose the remainder of the credit. If you only paid $500 in taxes and had a $1,000 credit, you'd use the credit to reduce your tax bill to $0 but would not get back the other $500 from the credit.

If a credit is refundable, on the other hand, you would get back that $500. This would mean that if you had a $500 annual tax bill and were entitled to a $1,000 tax credit, you'd pay no taxes for the year and the IRS would send you a $500 refund check in the year when you claimed the $1,000 credit.

A tax attorney can help you to ensure you are claiming all of the credits and deductions that you could potentially be eligible for, and can help you to prove your eligibility for deductions and credits if the IRS has questions about whether your credits or deductions were appropriate and audits you to determine if you complied with the rules. Contact tax attorney Kevin Thorn today to find out more about the assistance that we can provide to you.

Thorn Law Group is an IRS tax law firm comprised of attorneys practicing and giving advice in the areas of IRS, Tax, audits, voluntary disclosures, IRS Office of Professional Responsibility ethics cases, offshore accounts, amnesty programs, in Washington DC, Baltimore, Maryland, Virginia, New Jersey, Florida and throughout the United States.